Risk Premium | Why do real estate prices fall when interest rates rise? [Mumu's Investment Terms]

“Real estate stocks fall as interest rates rise”

This is a sentence I often see in the news. Honestly, I didn’t quite get it at first. Isn’t real estate supposed to be resistant to inflation? Since rents go up too, why do prices fall?

In fact, this autumn, as long-term interest rates exceeded 3%, major real estate stocks have fallen significantly from their highs. When I looked into it, the key was the term “risk premium.”

■ First, a quick quiz

Suppose you have 1 million yen on hand.

A: Lend it to the government (government bonds). You get 1% interest every year, almost guaranteed.
B: Invest in an apartment. 4% rental income every year. However, there is a risk of vacancies and repairs.

I would consider B. If I can get 3% more, I can tolerate some risk.

Now, what if the interest on A becomes 3%?

The difference with B is only 1%. Would I want to get 1% more while worrying about vacancies and repairs? I would choose A without hesitation.

■ Risk premium = “compensation for patience” for risk

This additional amount, which says “if I take a risk, I must get this much more to make it worth it,” is the risk premium. It is easier to imagine it as “compensation for patience” regarding risk.

The benchmark is the yield on government bonds. Adding the compensation for patience to that becomes the yield that investors demand from real estate.

・Government bond 1% + compensation for patience 3% = 4%
・Government bond 3% + compensation for patience 3% = 6%

■ When the required yield rises, the price falls

Real estate prices are roughly determined by “rental income ÷ required yield.”

For an apartment that brings in 4 million yen in annual rent,

・For someone demanding 4%, 4 million ÷ 4% = 100 million yen
・For someone demanding 6%, 4 million ÷ 6% = approximately 67 million yen

Even though the rent remains exactly the same, you won’t be able to sell the property unless you lower the price by more than 30 million yen. This is the reality behind why ‘real estate prices drop when interest rates rise’.

■ The part I found most insightful

What I realized while researching is that there is nothing wrong with the property itself. The rent is still coming in, and the vacancy rate hasn’t increased. What changed is the ‘benchmark’ we compare it against: government bonds.

Real estate companies are posting record-high earnings, yet their stock prices are falling. This cleared up some of the confusion I mentioned in my previous article.

■ The same applies to stocks

Actually, this ‘patience premium’ also exists for stocks. It is particularly influential on growth stocks, which are bought based on expectations of future profits. I plan to write about this in the ‘Growth Stocks’ installment of this series.

■ Summary

・Risk premium = The extra profit expected in exchange for taking on risk (patience premium)
・The benchmark is the yield on government bonds
・When interest rates rise, the required yield for real estate and stocks also rises
・Even if the property itself doesn’t change, the price drops simply because the benchmark has changed

Since learning this term, I’ve been able to think a bit more about why news headlines say things like ‘XX stocks fall due to rising interest rates’.

At what percentage of government bond interest would you choose government bonds over an apartment? Please let me know in the comments if you’d like.

※ This article is for informational purposes only and does not recommend the buying or selling of any specific stocks.